Principal Issues: 1) For the purpose of a foreign tax credit claim under subsection 126(2) in respect of the State of New York tax paid by a corporation, how should "qualifying incomes" and "qualifying losses", as defined per subsection 126(7), be determined for the application of paragraph 126(2)(b)?
2) For the purpose of a small business deduction claim under section 125, how the corporation's income for a year from an active business carried on in Canada should be determined?
Position: General comments, question of fact.
Reasons: Application of paragraph 4(1)(b).
XXXXXXXXXX 2008-028094 Yannick Roulier February 9, 2012
Dear Madam:
Subject: Determination of Foreign Income under Sections 125 and 126
This is in response to your letter of June 2, 2008. In that letter, you requested our opinion regarding the determination of income from a business carried on in a foreign country for the purposes of computing the foreign tax credit ("FTC") provided for in subsection 126(2) of the Income Tax Act (the "Act") and the small business deduction ("SBD") provided for in section 125. We apologize for the delay in responding to that request.
Unless otherwise indicated, all statutory references below are to the provisions of the Act (R.S.C. 1985, (5th Suppl.), c.1) as amended, in effect as of the date hereof.
Hypothetical Facts Submitted
Our understanding of the hypothetical facts submitted is summarized as follows:
1. Canco is a "taxable Canadian corporation" within the meaning of subsection 89(1).
2. Canco carries on a freight transportation business. Travel is exclusively between two points in Canada or between a point in Canada and a point in the United States.
3. Paragraph VIII(4) of the Convention between Canada and the United States of America with respect to Taxes on Income and on Capital (the “Convention”) exempts Canco's income from any US federal income tax referred to in Article II of the Convention.
4. Canco is subject to New York State tax by reason of its use of the state's highway system in the course of its business. It must file a CT-3 General Business Corporation Franchise Tax Return ("CT-3 Declaration") with the tax authorities of that State.
5. That tax generally corresponds to the highest of the following amounts:
(a) A tax at a fixed percentage of the "Entire net income base";
(b) A tax on the "Capital base";
(c) A tax at a fixed percentage of "Minimum taxable income";
(d) A fixed amount determined for the year based on different parameters.
6. The "Entire net income base" is established using the taxable income of a corporation determined under US federal tax rules multiplied by a business apportionment factor.
7. The "Capital base" includes the average net worth of a corporation's assets in a year multiplied by a business apportionment factor.
8. Business apportionment rules apply specifically to businesses operating in the field of freight transport and provide for a breakdown according to the distance traveled in the State's territory ("Apportionment factor").
Questions
1.) In calculating the FTC under subsection 126(2) in respect of the State of New York tax paid by a taxpayer, how should qualifying incomes and qualifying losses, as those terms are defined in subsection 126(7), be determined for the purposes of paragraph 126(2)(b)?
2.) In the context of the SBD claim under section 125, how should the income for the year from a business carried on elsewhere than in Canada and not giving rise to that deduction be determined?
Comments
The situation described in your letter is an actual situation involving taxpayers. As stated in paragraph 22 of Information Circular 70-6R5 issued May 17, 2002, it is the practice of the Income Tax Rulings Directorate of the Canada Revenue Agency ("CRA") not to issue a written opinion regarding proposed transactions otherwise than through advance rulings. Furthermore, when it comes to determining whether a completed transaction has received adequate tax treatment, the decision is made by the CRA tax service offices. However, we can offer the following general comments which we hope will be of assistance. These comments are technical interpretations that are not binding on the CRA and may, under certain circumstances, not apply to your particular situation.
1) FTC provided in Subsection 126(2)
Eligibility of the Tax
In general, the FTC granted under subsection 126(2) to a taxpayer for a taxation year is the least of the amounts determined under paragraphs (a), (b) and (c) of that provision. A tax that does not qualify as a "business-income tax" as defined in subsection 126(7) results in a nil result in paragraph 126(2)(a) and prevents any claim for an FTC by virtue of subsection 126(2).
The eligibility of a tax for the purposes of that measure requires, among other things, that the taxpayer carry on a business in the foreign country. That is a question of fact that must be analyzed in light of the Canadian taxation rules. There can be the same business as the one carried on in Canada or a separate business. Subsection 248(1) defines the term "business". It is also generally recognized that the existence of a business carried on by a taxpayer requires, among other things, a certain consistency and continuity.
In addition, there must be an "income tax" that relates to income from a business carried on outside Canada. In accordance with the information submitted, the tax levied by the State of New York and calculated in accordance with the terms set out in the CT-3 Declaration can be established in four different ways. The method used to determine the tax payable for a year by a taxpayer and the method of calculating it are relevant to determining the tax treatment to be adopted. We refer you in this regard to Interpretation Bulletin IT-270R3 - Foreign Tax Credit issued on November 25, 2004 ("IT-270R3") for a statement of the applicable principles.
The method of calculating the "Entire net income base" substantially resembles the income and profits taxes imposed under Part I of the Act. Thus, it appears to us, in general, that in the case where the tax levied by the State of New York is determined on the basis of an “income”-type tax, an FTC could be claimed by the taxpayer, subject to other requirements for the application of subsection 126(2). However, we did not analyze all the parameters for determining the tax payable to the State under that method of calculation, nor the adjustments made to US federal income to establish the "Entire net income base". Certain terms and conditions could lead to the determination of a tax base that would require additional comments involving reservations regarding the characterization of the tax.
Your request does not tell us whether the State of New York recognizes the application of the Convention for the purpose of computing income under US federal tax rules in the determination of tax using the method involving the "Entire net income base". If so, that method of calculation would give a nil result in the hypothetical situation submitted since the taxpayer's income would not be subject to US federal tax under the Convention. The incorrect payment of tax under that method would not allow a taxpayer to claim an FTC under subsection 126 (2). We refer you in this regard to paragraph 11 of IT-270R3. Otherwise, the methods for determining the tax base and the State apportionment factor should be analyzed together to determine whether it is reasonable to determine that the tax calculated according to foreign tax rules refer to income from a business that the taxpayer carries on in that jurisdiction. In that regard, the source of income or loss should generally be determined in accordance with paragraph 4(1)(b).
We are furthermore of the view that any other method of determining the New York State tax could not give rise to a claim for an FTC pursuant to subsection 126 (2). In those circumstances, the amount of tax paid by a taxpayer could be deductible against the taxpayer’s business income, depending on the nature of the payment and the applicable provisions of the Act.
Qualifying Income and Loss
Generally, subsection 126(2.1) provides that " the tax for the year otherwise payable under this Part" is multiplied by the fraction represented by the ratio between "qualifying incomes" minus "qualifying losses" to the taxpayer's adjusted taxable income for the purpose of determining the amount in paragraph 126(2)(b). We refer you back to IT-270R3 for an explanation of the applicable rules.
Subparagraph 126(2.1)(a)(i) requires "qualifying incomes" and "qualifying losses" to be derived from businesses that the taxpayer carries on in the country for which the credit is calculated. The determination of the existence of a business is, such as for the purposes of paragraph 126(2)(a), a question of fact to be resolved under Canadian taxation concepts.
Furthermore, "qualifying incomes" and "qualifying losses" are expressions defined in subsection 126(7) and must be calculated by applying subsection 126(9). Their determination entails the application of the general rules of the Act, including sections 3 and 4. The purpose of that approach is to establish the business income earned by the taxpayer in the country in respect of which a credit is claimed. In that context, subsection 126(9) provides for certain exclusions and specific calculation procedures applicable in certain circumstances. Among other things, "tax-exempt income" within the meaning of that expression in subsection 126(7) is excluded from "qualifying incomes" under subparagraph 126(9)(a)(iii). Thus, recognition by New York State of the Convention would be a relevant consideration for the purpose of applying paragraph 126(2)(b).
The determination of a taxpayer's "qualifying incomes" and "qualifying losses" requires the identification of the taxpayer’s sources of business income. In that regard, no specific formula or rules are provided for in the Act or the Income Tax Regulations (the "ITR") for the purposes of subsection 126(2). The general rules for determining the source of income, losses and deductions provided for in paragraph 4(1)(b) must therefore be applied, all as specified in subsection 4(3). Paragraph 4(1)(b) could be textually interpreted to require the computation of items of income distinctly with respect to each of the places where the business of a taxpayer is carried on. In practice, however, this provision is generally applied to allocate the income, losses and deductions of a taxpayer on a jurisdictional basis.
This approach requires an analysis of all the facts of a particular situation. The allocation method adopted must generally be established in a reasonable and appropriate manner depending on the taxpayer's business location. It must also be applied consistently by the taxpayer for as long as it carries on its business. The currency used for payment or billing purposes is irrelevant for determining the territorial source of a taxpayer's income.
Income allocation based on the ratio of distance traveled in a jurisdiction over the total distance traveled is generally not acceptable under subsection 126(2). That is a simplified method that does not take into account all the facts applicable to a particular case. In addition, it should be noted that the methods for allocation for a business established by sections 400 and following of the ITR cannot be used in allocating income, losses and deductions for the purposes of subsection 126(2). Those provisions are applicable only in the context of determining the deduction provided for in section 124. The same applies a fortiori with respect to the business distribution rules adopted by a foreign jurisdiction.
If a taxpayer's business activities in a foreign country are incidental to its Canadian business, it may be reasonable to consider that the taxpayer is not carrying on business in the foreign country. In that regard, we refer you to paragraph 24 of IT-270R3.
2) SBD provided for in Section 125
The determination for a taxation year of the income from a business carried on in Canada by a taxpayer that qualifies for the SBD provided for in section 125 also requires the identification of the territorial source of the of the business income of the taxpayer. In practice, "foreign business income after deducting related expenses" must be reported on line 500 of Schedule T2 - 7 "Calculation of Aggregate Investment Income and Active Business Income (2009 and later tax years)".
As is the case for the purposes of subsection 126(2), the Act or the ITR do not provide for any specific formula or rules for allocation of a business for purposes of the application of section 125. The general rules for the determination of the source of income, losses and deductions provided for in paragraph 4(1)(b) must therefore be applied. For greater clarity, note that income from a business carried on abroad may not be included in income from a business carried on in Canada for the purposes of calculating the SBD of a taxpayer under section 125.
We hope that our comments will be of assistance.
Best regards,
Guy Goulet, CA, M. Fisc.
for the Director
International Operations Division
Income Tax Rulings Directorate
Legislative Policy
and Regulatory Affairs Branch